Global Financial Markets: The Dr. Jeckyll and Mr. Hyde Syndrome

``Historically, the government has kept the Taiwan dollar under a tight reign, so as to deter unwanted appreciation that might harm exporters' competitiveness. In my view, this same policy has hindered the country's ability to develop a robust service sector. Top-tier knowledge workers rarely derive their advantage from a "cheap" currency, but rather from the sheer global competitiveness of their skills and services. Given that such workers can sell their services most anywhere in the world, they have little incentive to reside in a country whose currency policy steadily erodes the purchasing power of their income and savings.” Andrew T. Foster, Director of Research, Portfolio Manager, Matthews International Capital Management, LLC

An 1886 classic by Scottish novelist Robert Louis Stevenson, “A Strange Case of Dr. Jekyll and Mr. Hyde” depicts a tale of a person’s internal “good versus evil” conflict; a personality switch struggle triggered by a scientific experiment which transmogrifies the respectable Dr. Henry Jeckyll into a hideous murderer in Mr. Edward Hyde. The story ends with the dearth of the potion required to bring Mr. Hyde back to his original state or Dr. Jeckyll, where “both” eventually dies.

The financial markets today seem to illuminate of a Dr. Jeckyll and Mr. Hyde syndrome.

On one hand, Dr. Jeckyll appears to be represented by the equities side, which has seemingly been placid and convalescent following the recent bouts of transformation from Mr. Hyde, prompted by the August subprime led shakeout.

On the other hand, the vicious strains of Mr. Hyde have been quite evident in the persistent arterial blockages in the global credit market, the continuing maelstrom in the currency markets and the accelerating perceptions of a sharp economic downturn in the US possibly percolating to the rest of the world.

Where the balancing of the asymmetric conditions of Dr. Jeckyll and Mr. Hyde requires a certain magical potion, its functional equivalent in today’s milieu is the financial engineered credit-driven liquidity structure that has underpinned the sustainability of the current system as shown by derivatives expert, Satyajit Das in Figure 1.

Figure 1: Satyajit Das: The New Liquidity Factory

Mr. Das describes of the transformation of the credit system from the traditional banking driven process to a “borrowing money from borrowed money” structure, we quote Mr. Satyajit Das (highlight mine),

``In the new liquidity factory, investors did the borrowing - hedge funds borrowed against investments; traders borrowed cheap money (especially yen at zero interest rates) to fund high yielding assets in the famous carry trade. Financial engineering disguised leverage so that an investor’s balance sheet today does not tell you the amount of leverage being employed.

``The new liquidity factory is self-perpetuating. If you bought assets with borrowings then as the asset went up in price you borrowed more money against it. In an accelerating spiral, asset prices rise as debt fuels demand for the asset. Higher prices decrease the returns forcing the investors to borrow more to increase returns. Bankers became adept at stripping money out of existing assets that had appreciated in price, such as homes. In the USA, UK and Australia – the fast debt nations - home equity borrowing funded a frantic debt addiction.”

In a pyramid framework, the present liquidity has principally been built from the bottom, where layers and layers of leverages consisting of securitized debt and derivatives comprise the majority of what drives the global financial markets.

The astounding degree of leverage has been estimated as a percentage of GDP and as a share of liquidity distribution by Mr. Das, which implies that the present financial system has increasingly been über sensitive to interest rates, price actions and volatility fluctuations.

The recent perky equity markets adamantly believe that global central banks led by the US Federal Reserve will be able to successfully plug and repair the recently punctured structure as a result of the deepening US housing recession impelled security losses, and the sustain the party.

We hope they are right and Dr. Jeckyll prevails.

Dr. Jeckyll’s Ace: The Rupturing US dollar?

``In capitalist financial markets, discipline and prudence require that investors fear – yes, fear – that they can lose; and lose big time. Nonetheless, there can be no denying that a Fed Put does exist; indeed, that was the primary reason the Fed was created in 1913, to provide an "elastic currency" so as to truncate cycles of panic that predated its creation.”-Paul McCulley PIMCO

However, our understanding is that under the Minsky’s Ponzi finance scheme, credit requires even more credit to ensure rising prices to sustain operations. Hence, the foremost question in our minds…will the global central bank administered potions regenerate enough “velocity” of credit to sustain its momentum and place Dr. Jeckyll as the dominant market personality? Or will its paucity lend to the Stevenson classic denouement?

Meanwhile Dr. John Hussman of the Hussman Funds argues that all the jubilation over the recent expectations of a successful Fed intervention has been downright misleading since he says (highlight mine)``there is no credible mechanism by which Fed actions control the economy.”

Dr. Hussman argues that the investing world bolstered by media needlessly fixates on the sensational and the trivial without propitiously examining the extent of the overall impact of the ongoing transitional process.

We quote Dr. Hussman, ``It's important to emphasize that the impact of these changes is mainly psychological, and outside of a pool of a few billion dollars, won't have any effective bearing on the “liquidity” of the banking system, nor on the solvency of $3.4 trillion in real estate loans, and $6.3 trillion in total bank lending.” See figure 2.

Figure 2: Hussman Funds: The Fed: Magical Fairies and Pixie Dust

From an earlier article Dr. Hussman’s pungent observation anew, ``The total amount of U.S. bank reserves affected by FOMC operations is less than $45 billion, and only the “excess” portion of that – typically about one billion dollars – is what determines the overnight Federal Funds Rate. Meanwhile, the total amount of borrowings through the “discount window” – though higher than in recent years – still amounts to only about $3 billion.”

In essence, central bank operations including the rate cuts influence only a minor segment of the entire banking based US financial system. His argument separates the forest from the trees, where Central bank operations will likely do little to resolve the current insolvency problems, except that it has and could further influence the market through psychological means temporarily.

But there appears to be a shadow banking system, which we have earlier discussed, in our September 10 to 14 edition [see US Commercial Paper Markets: A Run on The Shadow Banking System?], where as we quoted Paul McCulley of PIMCO, “the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures…which may or may not be backstopped by liquidity lines from real banks.” The shadow banking system is tantamount to Mr. Das’ new liquidity factory.

The issue here is one of leverage, where margin based positions have amplified the impacts on the earning quality of assets especially for those thriving on scanty 1-2% returns. Marginal interest rate or price action movements magnify gains or losses for these structures. Ergo, lower rates could be expected to help cushion on the impact of loan losses and higher borrowing spreads.

Nonetheless, could a psychological booster be enough to uphold the Dr. Jeckyll good natured being without backsliding to Mr. Hyde?

The US equity markets, which we believe as the inspirational leaders of the global equity markets, including our Phisix, has substantially recovered following a short episode of a near Mr. Hyde metamorphosis.

For the third consecutive week, US major equity benchmarks has regained most of its losses and in fact is just a breath away from restoring its old glory. Nevertheless, today’s euphoria has been borne out of the continued expectations of the “FED-Bernanke Put” therapy.

Let us scrutinize why US markets have steadily remained upbeat in spite of the cognizance of growing “wall of worries”.

An article from Vikas Bajaj of New York Times, says that the US markets has positioned away from endogenous developments and instead focused on earnings from external factors. To excerpt Mr. Bajaj (emphasis mine),

``The market appears to be buoyed by a belief that the problems in the housing and credit markets will not be severe enough to pull the broader economy into a recession and that growth in Europe and Asia will help offset those ill effects. The optimism is most vividly manifest in the performance of foreign stock markets, particularly those in the fast developing nations like China and India. One widely followed index that tracks emerging markets is up about 24 percent since Aug. 16, when it hit a low point. Markets in developed countries excluding the United States are up about 12 percent in the same time.

``Even in the United States, the market’s return has been led by industries like materials, energy, technology and industrials that investors believe are best positioned to take advantage of the growth in foreign markets. By contrast, the financial and consumer discretionary sectors have lagged because they are seen as having the most to lose from a declining housing market and slowing consumer spending domestically.”

Figure 3: Standard & Poors: Sectoral Performance Breakdown as of Sept 28th

Mr. Bajaj’s observation appears to be accurate enough, as sectors with prominent exposures to world markets or are highly levered to global developments continue to deliver the gist of the gains (see figure 3), particularly Energy, materials, industrials, information technology, and telecoms. About half of the earnings from the large transnational companies are derived from outside of the United States.

In contrast, financials, consumer discretionary, health care, consumer staples and utilities are sectors mostly devoted to internal dynamics hence the recent underperformance brought about by the continuing housing recession and the downshifting pace of economic growth.

Figure 4: Hang Seng Sectoral Performances: Almost the Same Construct As S & P 500

In absence of available data from Japan or from Singapore, due to our unfamiliarity with their websites, the sectoral performance of Hong Kong’s Hang Seng index peculiarly shows of almost the same performance as with the US led by Materials, Energy, Telecoms and Industrial goods. Put differently, macro themes appear to have diffused in diverse markets.

With a tinge of similarity the Philippine Stock Exchange’s aggregate year to date gains of the local indices in pecking order: Mining and Oil + 62.82%, Property +27.82, Phisix +19.79%, ALL index +19.69%, Holding Firms +17.43%, Services +16.73%, Industrials +16.05% and Financials +10.41%.

Now we believe that global growth is only ONE dimension of the entire picture. The other spectrum omitted by the NYT article is the most important operative—the LIFETIME LOW of the US Dollar Index!

With the US dollar trade weighted index losing its purchasing power as reflected by its continued decline against the currencies of its major trading partners (aside from the rest of the world), hard assets as commodities have been steadily gaining in value.

Hence, the expectations of a resurgent inflationary climate as well as investments themes aimed at inflation directed dynamics. Why do you think, materials and energy have been the global best winners of late?

Since commodities are major export products of emerging countries hence, rising commodity values undergirds their export strengths and consequently an important contributor to their economic output.

So it is quite logical that a declining US dollar has fueled a recovery in emerging markets equities (dependent on rising commodities) which likewise powered US large multinationals earnings outlook, hence the strength in the US markets.

On Friday, the widely followed and respected independent Canadian research outfit the BCA Research noted of the snowballing “Anti-U.S. Housing Trades” themes in the…

Figure 5: BCA RESEARCH: Anti US Housing Trades

``Global portfolio investment flows continue to move towards equities, commodities and currencies that are farthest from the U.S. housing market, i.e. away from the epicenter of economic weakness. The relentless slide in the stock prices of U.S. subprime lending companies is ominous for homebuilding stocks. In fact, subprime lenders' stocks hit new lows Wednesday, despite the rally in the S&P 500 index during the past week! Conversely, emerging market equities have completely recovered, hitting a new high. Meanwhile, the dollar continues its steady downtrend, reflecting waning interest in U.S. paper as a consequence of relatively unattractive economic and investment prospects. In sum, the environment is the opposite of the 1990s, when the dollar and U.S. equities were king.”

What goes around comes around. What we used to believe as US inspired equity leadership appears to have now gradated into a US dollar DIRECTED global recovery which seems to have underpinned the US markets of late.

So, could Dr. Jeckyll have found a new ingredient to postpone his day of reckoning?

Maybe. It all depends on HOW the financial markets will respond to a US recession or a credit shock should there be one.

Be reminded that economics is NOT solely the pillar of financial markets or in particular, equity markets. As in the case of Zimbabwe which has suffered successive years of hyperinflationary depression, monetary administration in support of corrupt and perverted fiscal policies has been responsible for destroying its national currency value which subsequently has channeled excesses money creation into stock market speculation, which we dealt in our September 3 to 7 edition [see A Global Depression or Platonicity?]. Even today, the Zimbabwe’s Stock Exchange continues to fly!

In short, Dr Jeckyll’s recipe for sustenance has been and continues to be from:

1. Mainstream expectations that Global Central Banks led by Chairman Bernanke will continue to lean on accommodative policies which focuses on economic growth and forestall a sclerosis in global credit flows while erring to the side on inflation.

2. Mainstream expectations have likewise been grounded on continued global economic strength to offset the slack in the US economy, which should avoid a recession, and/or lastly

3. The UNSEEN driver in the form of a cratering US dollar which could have stoked an inflationary mindset in the global investment community leading to inflation directed investment themes.

Mr. Hyde’s Three Leaf Clover and the Russian Roulette

``Investors and lenders convinced themselves that financial alchemy would turn illiquid securities into liquid securities in all market conditions. But leverage and liquidity require two participants. A borrower needs a lender, and a buyer needs a seller. Otherwise each is just a ship at sea. Liquidity is a human phenomenon, a psychological phenomenon. Investors made the mistake of believing that financial technology had repealed the laws of human nature.” -Michael Lewitt, Hegemony Capital Management, Vectors of Credit

So markets have essentially been rising on the account of global rescue packages deemed as inflationary, but Mr. Hyde maintains his presence felt in the financial system amidst such perky expectations.

Here are some signs that Mr. Hyde still lurks in far corner waiting for the right opportunity to pounce:

A continued rise in interbank lending rates as shown in Figure 6…

``The London interbank offered rate that banks charge each other for overnight loans in pounds rose 20 basis points to 6 percent today, the highest in 10 days, British Bankers' Association figures showed. The corresponding rate for dollars rose 21 basis points to 5.30 percent, and the euro rate climbed 6 basis points to 4.23 percent.” September 27^th Bloomberg,

Figure 6: stockcharts.com: Widening spreads signs of tranquility?

While some semblance of restoration of order has been seen in the credit markets, widening spreads have not been encouraging signs of tranquility.

ECB Banks continue to tap emergency funds…

``The European Central Bank’s emergency lending fund, which attracts a penal interest rate, was tapped on Wednesday for €3.9bn, the largest sum since October 2004, the Frankfurt-based institution has revealed.

``The surge in demand for the ECB’s “marginal lending facility” points to the difficulties still being faced by European banks as a result of the global credit squeeze.” September 27^th Financial Times

Again from Dr. Hussman’s perspective, the amount broadcasted by media as accessed by banks is basically miniscule compared to the overall securities affected by the recent credit gridlock.

And in Canada, paralysis continues in the short term funding for Asset Back Commercial Papers market (ABCP)…

``The Canadian cash crunch that started with defaults on subprime mortgages in Southern California and Florida has hurt more than 25 companies that invested in commercial paper, including Sun-Times Media Group Inc. and Canada Post, the nation's mail service. Baffinland has 95 percent of its cash in Canadian commercial paper, debt that is due in 364 days or less.

``Investors fled Canada's asset-backed commercial paper, paralyzing the C$40 billion market for debt that carried the highest credit ratings, after losses from home loans to people with poor credit histories roiled global credit markets.” Bloomberg September 25^th

In the US, Commercial Paper Markets continue to shrivel…

``The U.S. commercial paper market shrank for the seventh straight week as the Federal Reserve's interest rate cut fails to improve conditions for short-term credit.

``Debt maturing in 270 days or less continued its biggest slump in seven years, falling $13.6 billion in the week ended yesterday to a seasonally adjusted $1.855 trillion, including a $17.3 billion decline in asset-backed commercial paper, according to the Federal Reserve in Washington. The week's decline is smaller than the previous week's drop of $48.1 billion, a sign that buyers are starting to return to the market after the Fed's half-point reduction Sept. 18 in its benchmark interest rate.” Bloomberg September 27^th

In contrast to the news presentation, a smaller degree of decline is no evidence that buyers have emerged.

Moreover, credit paralysis has been a worldwide phenomenon, now with its tentacles reaching Russia…

``Overnight lending rates in Russia climbed to 10 per cent, the highest since mid-2005, even after the central bank on Wednesday pumped an additional $2.56bn into the banking system via two one-day repo auctions. Traders and bankers said the spike came as companies and banks prepared to make a monthly round of tax payments and primed their accounts to meet central bank requirements in time for end of third quarter financial reports…

``The Central Bank was also forced to pump liquidity into the system via repo auctions at the end of August after foreign investors fled Russian money markets amid the flight to quality following the US subprime crisis and tax payments fell due. Russia racked up more than $5bn in net capital outflows in August.” September 26^th Financial Times

Notwithstanding, the bleak outlook from the IMF suggesting the credit driven volatility will most likely continue to affect the global financial systems….

``The global financial system has undergone an important test and the test is not over yet. Implications of this period of turbulence will be significant and far-reaching," Jaime Caruana, IMF director for monetary and capital markets departments, told a news conference…

``IMF Managing Director Rodrigo Rato said the impact on global growth from the credit crunch and re-pricing in credit markets will be felt in 2008 and that the United States will most likely be hardest hit.

``He said world economic growth should remain strong next year but looks set to be below the levels of 2006 and 2007 and downside risks increase the longer financial markets remain in crisis, Rato told a seminar in Madrid.” September 24^th Reuters.

Telegraph’s Ambrose Evans Pritchard says that US leading investment broker Goldman Sachs, previously a key proponent to the global decoupling theme, appears to have been proselytized to camp of the bears…

``Goldman Sachs has abandoned its ultra-bullish view of the world economy, warning of a likely recession in Japan and mounting risks that US property slump could spread to parts of Europe.

``In a new report, "The Global Economy Hits a Crunch", the US investment bank said it was no longer sure that Asia and Europe would be able to pick up the growth baton as America stumbled. It fears that turmoil is spreading beyond the debt markets to the factory floor.”

In short, Mr. Hyde still has a commanding presence that may shift the war of psychology in his favor with three apparent risks variables at play…the prospective escalation of the credit bottlenecks, a US led economic recession percolating to a global slowdown and a chaotic unraveling of the US dollar.

To say that Central bankers appear to have successfully cleared the hurdles as evidenced by the rising markets is analogous to playing the “Russian Roulette”…

Just because the first two shots were fired and you survived does not imply the revolver’s 4 remaining chambers are not loaded.

Gold: Surging Across Diverse Currencies! Policy Responses Should Favor Present Momentum

``When the Central Bank sells assets to the banks or the public, it lowers bank reserves, and causes pressure for credit contraction and deflation—lowering—of the money supply. We have seen, however, that governments are inherently inflationary; historically, deflationary action by the government has been negligible and fleeting. One thing is often forgotten: deflation can only take place after a previous inflation; only pseudo-receipts, not gold coins, can be retired and liquidated.” -Murray Rothbard, What has Government done to Our Money

For some, the rise in gold prices is just a normal function of markets and should be cheered about.

For us, rising gold prices, especially on a worldwide currency scale such as rising gold price in EUROS (!) see Figure 7 (and against most major currencies…except the Canadian dollar), evinces strains in the global monetary frontiers and do not represent an optimistic outlook. Therefore, we find metals and metal related assets as an instrument of hedge. (I have been saying this since 2004)

Figure 7 James Turk’s Goldmoney.com: Gold rising in Euros

As we have long argued, we believe that further strains in the financial system would lead policymakers to an almost perpetual loop for political treatment based short term solutions, whose actions includes effecting rescue packages for its constituents (banks) at the expense of the general population by debasing its currency.

Such is the natural inclinations provided for by the Fractional banking system, the functional operating system of today’s Fiat Currency Standard.

Political pressures like those applied by media--imagine the unnerving sight of snaking lines of depositors during a bank run similar to those of UK’s Northern Rock--which politician will not be prompted to act on the behest of the protecting depositor’s welfare simply because they represent significant number of votes? Otherwise be seen as insensitive and irresponsive incumbent bureaucrats.

Besides, inflationary mechanics have never been truly understood by the public, whom are mostly obsessed with short-term gratifications (the Philippine Senate hearings should be an example), which is why inflation is a favored tool by politicians and their factotums (think interest rate and currency manipulations, gold sales and etc…)…a concealed tax.

Paper money has been founded on mere trust on the government’s ability to repay its obligations. Whereas history tells us that governments in any forms unbacked by the gold standard almost always steal from its constituents by repaying debt in devalued currency, if they ever repay at all (or by default).

On the other hand, Gold is no one’s liability. In the words of the great Ludwig von Mises (highlight ours), ``The gold standard has one tremendous virtue: the quantity of the money supply, under the gold standard, is independent of the policies of governments and political parties. This is its advantage. It is a form of protection against spendthrift governments.”

The steep decline in the US dollar mirrored by the rise of gold prices simply suggests to us that there could be a countertrend or correction soon, as no trend goes in a straight line. Yet the chances of an auspicious momentum, for a sustained run perhaps until the yearend, seem to look good for our alternative money. A gold price of $800 target to $850 looks attainable GIVEN THE SUSTAINABILITY of the present conditions.

Nonetheless, we also see the US bellwethers in the Dow Jones Industrials 14,000 and S&P 500’s 1,555 as important barriers. Failure to surpass previous highs could potentially mean a retest of its August lows otherwise we could see a consolidation. However, it is quite interesting to see if the NEW DYNAMICS will be sustainable: the falling US dollar supported buoyancy in US equities or if the “anti-housing trade” should help US equities higher.

The fate of Emerging markets will similarly respond to the direction of the US dollar index. These cross currents have given us some clues as to where the long term trend is likely to proceed. We will position accordingly.

Yet given the risks scenarios, we shouldn’t discount financial shocks.

However, the odds favor that policy responses will be tilted towards ensuring the safeguards of the financial institutions and the preservation of the present monetary system, despite the mounting pressures for its unraveling in the distant future (postponing the day of reckoning).

Post-US dollar breakdown and gold breakouts…

Stay long gold, Mines and Asian Currencies!

Bernanke’s Put: Putting The Punch Back Into The Punchbowl!

``The great problem is, of course, how to provide such emergency relief without allowing it to degenerate into permanent relief; how to relieve the extreme distress of those who are poor through little or no fault of their own, without supporting in idleness those who are poor mainly or entirely through fault of their own. To state the problem in another way (as I have earlier done): How can we mitigate the penalties of failure and misfortune without undermining the incentives to effort and success?-Henry Hazlitt (1894–1993) founding board member of the Mises Institute, libertarian philosopher, economist, and journalist for The Wall Street Journal, The New York Times, Newsweek, and The American Mercury.

A surprising 50 basis point cut by the US Federal Reserve sent US equities to a bacchanalian revelry, which spontaneously reverberated across the globe.

Equity bulls were quick to broach on the receding risks of recession and the gridlock in the global credit system as a consequence to the magical stroke of liquidity injection which should keep the shindig going. Analyst Doug Noland quotes a comment of former U.S. Treasury secretary Paul O'Neill ``Fed put the punch back into the punchbowl."

Here is accompanying statement of the US Federal Reserve last Tuesday (highlight mine):

``Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

``Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

``Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”

As we have repeatedly pointed out, the performances of the financial markets has been proven to have the most bearing among the considerations of the US policymakers.

Since our monetary system operates on the standard of revolving leverages, where borrowed money bought even more borrowed money, such requires conditions that would propagate even more dosages of leverage or gearing to sustain the system, hence the Hyman Minsky’s Ponzi financing system or euphemistically the Fractional Banking System.

To subject the system to liquidity deceleration or to a contraction of leverage brings to fore systemic risks; the risks that the Paper Money Standard could unravel. In the words of financial derivatives expert and author of “Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives” Satyajit Das (highlight mine), ``Risk itself has changed significantly. Financial crises are less and less the result of economic downturns, geopolitical events or natural disasters. They are more and more the result of the structure and activity in financial markets. Financial crises now do not necessarily mirror the underlying real economy. Economic cycles have become less pronounced.”

Therefore, an economy greatly dependent on the kinesics of financial assets would inherently engender policy responses directed at its unceasing benedictions.

For those who propound the latest actuations by the FED as signifying pre-emptive or “proactive” actions eludes the rudiments of such dynamics.

For us, the FED’s unanticipated action could OBVERSELY be construed as a sign of PANIC.

An unchanged rate, regardless of the financial markets reaction could have represented “principled” banking at its finest. On the other hand, a 25 basis points cut could have ACKNOWLEDGED the problem, but seen in the light of CONTAINMENT. However, the 50 basis points cut PLUS a similar cut in the discount rates ACCENTUATED the FED’s apprehensions over the immeasurable and profound ramifications of the credit market seizure contagion! This comes amidst risks of “some inflation”, according to the FOMC statement, which is almost tantamount to throwing gasoline to quench the fire (see Figure 1)…

Figure 1: Barry Ritholtz: Fear of a Dollar Collapse, part II

From analyst Barry Ritholtz (highlight mine), ``Speaking of surges: As you can clearly see above (bottom left chart), the amount of MZM (repos) versus M2 during 2007 is enormous.

``This means that the Fed is "inflating" at a rate faster today than it did right after 9/11, or during the deflationary scare of 2003.”

The inebriate has been given his bottle of whiskey.

For us, the US FED and even the Bank of England’s “nationalization of deposits” of Northern Rock corroborates Nassim Nicolas Taleb’s Ethical Problem; the deep-seated nature of authorities for TREATMENT-based POLITICALLY MOTIVATED policies rather than preventive measures.

As evidence, the US dollar trade weighted index, which fell 1.33% this week (see figure 2), has been sacrificed in the altar of today’s monetary system in exchange for the survivorship of its natural constituents.

Figure 2: fxstreet.com: US Dollar Index Plunges to Multi-year lows!

Daily Reckoning’s Bill Bonner excerpted economists Lewis & Clark poignant remarks whom we quote (emphasis mine), ``It seems intended to bail out the speculators on Wall Street...and the imprudent borrowers in the housing market...but it merely redistributes the losses onto the people who don’t deserve them – the general population of dollar holders, dollar earners, and dollar savers all over the world.”

Where mainstream experts mostly argue on the superficial aspects, particularly the symptoms of social or wealth inequality, a few of them fixate on the root causes…as the great Milton Friedman once said, ``Inflation is a form of taxation that can be imposed with legislation.”

Comparing Past Outcomes From FED Actions Is A Gambler’s Fallacy

``There are no facts, only interpretations”-Friedrich Nietzche

The euphoria in the global markets following the FED’s actions places a positive spin in an otherwise risk fraught landscape. Should this be instead reckoned as the proverbial “Wall of Worry” to climb?

Equity bulls revert to rate cutting antecedents such as in September 1998 (+25% in 6 months), July 1995 (+11%), June 1989 (+9%) and September 1984 (+5%) as prospective models, where policy actions benefited the equity markets, from which today’s markets could replicate. We hope they are right, but alas, hope is not a strategy.

However, the bulls equally dismiss on the subsequent 2001 tech bust as an “outlier” event for having the infamous 9/11 to “unjustifiably” weigh on the circumstances. Such argument we believe is selective perception or ``how we view our world to create or justify our own reality (Sherif & Cantril, 1945)”.

In essence, the bulls argue that in the realm of probability distributions, given the high success ratio of monetary policy actions as reflected by the market gains in the aftermath, the probability is thus weighted to favor market gains under the present circumstances.

How valid is such claim?

Figure 3: Economagic: Reprise of 2001 “Outlier”?

The US markets went on a wild ovation in response to the US Federal Reserve’s unexpected rate cuts. On Tuesday, the Dow Jones Industrials rocketed 2.51% (335 points), the broadbased S & P 500 soared 2.92% (43.13 points) and Nasdaq flew 2.71% (70 points).

Effectively, based on the dimensions of technical readings alone, the US markets are now in bull territory, which equally delivers most global markets including the Phisix into bullish grounds.

But given such developments, should we then join bandwagon? Not so fast, I believe.

The tech bust in 2001 appears to have manifested a parallel repertoire when the FED initiated its policy changes then.

In January 3, 2001 the FED “surprised” the market as it lowered its FED FUND rates by 50 basis points to begin its “preemptive” campaign to fight deflationary forces.

The US equity markets went into fabulous hyperdrive: the Dow sprung by 300 points or 2.8%, the S & P 500 zoomed by 5% (!!) or 64.9 points and even astonishingly the Nasdaq whizzed skywards by 14.17% (!!!) or 324.83 points. Again, notice of scale of gains by the US markets then, compared to last Tuesday.

Unfortunately such burst of adrenalin wavered as the one-day gains were wiped out in the coming sessions see figure 3.

In addition, the same chart tells us that the 9/11 outlier event argument occurred when the US economy was already suffering from the throes of RECESSION (see steep fall amidst the red shadow). Hence the tragic event aggravated the already deteriorating sentiments. In other words, even WITHOUT a 9/11 the markets then was into a CYCLICAL DECLINE.

Thus, since the 9/11’s relationship was COINCIDENTAL rather than CAUSAL, writing off the 2001 equation from the probability list was unwarranted.

Nonetheless, the basic difference between 2001 and today is that the US markets sputtered immediately while today’s markets have managed to hold its gains (yet?).

Figure 4: Economagic: long term view FED Funds and S&P 500

Another basic nuance cited by the bulls lending to the supposed “increased odds” for a positive outcome entails historical precedents that have come ABSENT recessions.

In figure 4, ALL policy changes (inflection points shown by the red line) SUBSEQUENT to or DURING recessions, marked by the red shadows, saw the US markets FALL.

In other words, the defining contrast of the probability distribution, following the FED rate cuts, SHOULD BE IF A US RECESSION OCCURS OR NOT.

One should be reminded that each of the said periods had distinct or dissimilar dynamics which influenced the financial markets then. And should NOT be lumped and generalized as similar with that of today.

Whether the markets will do a rhythmical reprise of 1998 as discussed in our August 13 to 17 edition (see US Markets: Unlikely A Reprise of 1998) or that of a 2001 appears to be a 50-50 odds given the above facts.

Assigning greater odds to a positive outcome is similar to a gambler’s fallacy (wikipedia.org), ``where the random event is the throw of a die or the spin of a roulette wheel, gamblers will risk money on their belief in "a run of luck" or a mistaken understanding of "the law of averages". It often arises because a similarity between random processes is mistakenly interpreted as a predictive relationship between them.”

A gambler’s fallacy can be exemplified by coin tosses. If a coin has been flipped five times and comes up with a series of “heads”, then the usual bet for the next toss would that of a “tail” since people would be inclined to think that the “law of averages” could deliver a “tail” outcome. But this ignores the fact that coin flipping is a 50-50 odds where each “flip” is INDEPENDENT of the results of the previous tosses, hence the fallacy.

So in the present environment where the recession prospects is a RISK concern, it would appear that as the chart shows, if the US falls into a recession the market goes down while if it escapes recession it could go up. In short, a 50-50 odds.

Now when bullish commentaries tells us that the previous streaks of rate cuts ended with a positive return, we understand these as prognosis shaded with a confirmation bias. And when they introduce probabilities using the same data in support of such claims, we also understand these as forecasting based on a gambler’s fallacy.

The bullish or bearish outcome will depend on a myriad of interacting factors such as the resolution of the bottlenecks in the global credit system, the reappearance of risk taking appetite, a return of confidence to the global financial markets, the strength of the global economy, the resiliency of the heavily levered US economy, the fate of the US dollar, political risks as growing protectionist sentiment and many, many more…

As The Us Dollar Falls, Stagflation Becomes A Reality

``Much has been written about panics and mania…. But one thing is certain; that at particular times a great deal of stupid people have a great deal of stupid money. At intervals… the money of these people — the blind capital, as we call it, of the country — is particularly large and craving: it seeks for someone to devour it and there is a 'plethora'; it finds someone and there is a 'speculation'; it is devoured and there is a panic." – Walter Bagehot, "Essay on Edward Gibbon"

In our previous outlooks we mentioned that given the mixed signals delivered by the markets, some of these would be resolved after the Fed’s action.

Well as Bernanke and Company waved the magic wand, indications became clearer, Bond Yields over the long end climbed, Gold surpassed its previous highs, the Baltic Freight index soared to record levels alongside ALL TIME HIGH Crude Oil prices, a crumbling US dollar index—all of which points towards the resurgence of inflationary pressures.

Figure 5: stockcharts.com: US Treasuries yield bolt higher

Figure 5 shows how the 30 year and 10 year treasury yields have surged following the FED’s actions while 3 month yields remains soft. The Yield spread of the 2 year and 10 year treasuries is at the highest level since May 2005.

A further steepening of the yield curve implies more inflation pressures. This should be confirmed by a motile rise in commodities as well as a drop in the US dollar, hence places the Bernanke in a box. Question is, could this lead the FED to a ONE and DONE move?

Since we are predisposed towards the view that the US monetary policies have been anchored to the developments in the financial markets particularly the equities market, its direction going forward would likely determine the FED’s next moves.

For instance, a continued surge in the equity market, or a Dow Jones breakout from the 14,000 levels could effectively put a tether on the future rate hikes, which is unexpected by the markets. On the other hand, a slippage of the Dow Jones Industrials back to the 10% loss levels could likely impel the FED to continue with its present phase of liquidity expansion.

While we see the more likelihood of a second scenario, we simply cannot discount the first. As we earlier said, markets can go either way from this point. Mr. Bernanke can further revise or rewrite lending rules, as they recently had--to accommodate more eligible collateral and they could print money and bonds to buy all those affected or “freezed-up” assets which could send US markets higher at the expense of the US dollar.

Moreover, a rising market may not imply diminished risks; not when GOVERNMENTS INSTEAD OF MARKET PARTICIPANTS THEMSELVES DRIVE THE MARKETS. Remember, markets today are heavily stacked towards the expectations of a “socialization” of the financial economy, where government interventions are greatly expected to deliver the elixir to the recent crisis. The argument for rate cuts has been synonymous to the arguments for political subsidies.

To consider, the threshold levels and record levels of gold, oil and the US dollar index is in itself a source of concern (figure 6). As we previously said, while mainstream analysis heavily discounts a US dollar crisis, we don’t see this as unlikely. The fact that the US dollar trades a few PIPS (price interest points) away from its LIFE time lows could trigger a massive and violent reaction either way. And violent reactions suggests of amplified volatility.

For instance, the US dollar fell heavily on rumors that the Saudi government would junk the US dollar peg and diversify AWAY from US dollar assets. This was apparently triggered by the Saudi Arabia’s government’s refusal to adjust rates alongside the recent US monetary actions, where since 1986 Saudi’s currency has been pegged to the US dollar at 3.75 riyals for every dollar, hence are required follow the interest rate policies of the US.

Quoting Ambrose Evans Pritchard of the Telegraph (highlight mine), ``This is a very dangerous situation for the dollar," said Hans Redeker, currency chief at BNP Paribas.

``Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," he said.

``The Saudi central bank said today that it would take "appropriate measures" to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg.”

With surging inflation as consequence to a US dollar peg, the oil rich Kingdom could finally break from its linkage as Kuwait last May.

Notwithstanding, in July according to the US Treasury International Capital System, net foreign purchases of long-term securities dramatically slowed to $19.2 billion from June’s $120.9 billon. This reflected the net foreign purchases by foreign official which declined to $4.4 billion in July from $53.8 billion in June.

In short, these could represent troubling evidences of the US dollar losing support as the de facto world’s foreign currency reserve. The denouement of which could reveal itself when prime commodities like oil get to be traded in ex-US dollar currencies.

For now, it is likely that as the US dollar swoons, the risks grows where pressure is felt by foreign holders of US dollar assets to slacken from adding more positions or to even become net sellers.

This is why as we have said last week we find gold and commodities and their proxies in the Philippine markets in the form of equities as possible HEDGES against risks from any financial crisis that could transpire.

Figure 6: stockcharts.com: Inflationary Landscape?

Yet, we remain UNCERTAIN of how a potential selloff in the US markets (assuming a recession comes to play) could affect Asian or Emerging Market or Philippine assets, although a soft US dollar has in the past provided important support to them.

We believe that Philippine mines should continue to outperform as the inflationary setting accelerates.

One should not forget that while governments’ control the money tap, the leakage from such actions will percolate unevenly, hence inflation may appear in any asset class from anywhere across the globe where such transmission permits. So while global economies downshifts, such inflationary scenario translates to a stagflationary outlook, an almost similar landscape that took place during the 1970s to the 1980s.

We also believe that Asia will be the strongest link if a negative correlation or a prospective decoupling occurs. Until evidences suggest of such dynamics becomes apparent, we will position only in small amounts to reflect on the risks we can afford to take as conditions warrant.

US Commercial Paper Markets: A Run on The Shadow Banking System?

``Federal Reserve independence is not set in stone…The dysfunctional state of American politics does not give me great confidence in the short run…and there may be ``a return of populist, anti-Fed rhetoric,'' Alan Greenspan ``The Age of Turbulence: Adventures in a New World” quoted from Bloomberg

In the financial sphere, it has been one heck of an interesting week where some ironic developments persist to unfold…

One, global central banks debate on how to resolve the present juncture…

Two, global equity markets continue to crawl higher despite the barrage of negative developments (are these salutary signs of “climbing the wall of worry?”) amidst conflicting messages seen across different markets and…

Lastly the Phisix survived the week with some bruises from an onslaught of foreign selling worst than during the August lows (!).

The Bank of England seemed to have assumed the “principled” path of central banking by adamantly refusing to go along the way of its peers in rescuing the money markets. It even rebuked the US FEDERAL RESERVE and the EUROPEAN CENTRAL BANK for “moral hazard” or by acting to bail out some banks last Thursday, from which we quote UK Central Bank governor Mervyn King (highlight ours), ``The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior, that encourages excessive risk-taking and sows the seeds of a future crisis.” Mr. King’s view was supported by Canada’s Central Bank Governor David Dodge.

Well, such rhetoric was good until Northern Rock, UK’s fifth largest mortgage lender, came knocking on its doors for liquidity support. Of course, there always has to be some justification; here is Bank of England’s statement, ``the FSA judges that Northern Rock is solvent, exceeds its regulatory capital requirement and has a good quality loan book.”

Incidentally, the problems at Northern Rock has NOT been due to US subprime papers but rather from banks reluctant to lend to each other, this from the Economist (highlight mine),

``Yet Northern Rock appears to be less of a protagonist in the current credit crisis than a bad case of collateral damage. Its problems were caused not because it risked its shareholders’ money on poorly judged investments linked to American subprime mortgages, as many far bigger and more international banks have. Instead, it has been hit by a failure to borrow from other banks to fund its mortgage lending practices. The interbank market where such borrowing usually takes place has partially seized up in recent weeks because big banks are hoarding as much capital as they can to pay for the cost of their own bad investments.”

As you can see, the ongoing liquidity drought in the credit markets has begun to affect the peripherals, as banks load up on their reserves to prepare for portfolio adjustments (losses).

Yet, much of today’s liquidity seizure has been seen via the US $2 trillion commercial paper markets.

Commercial paper markets are short-term (unsecured) debt instruments or promissory notes issued by financial and non financial companies with maturities ranging up to 270 days and an average 30 days (capital-flow-analysis.com). Such instruments are usually used by companies to fund their day-to-day operations such as inventory purchases or manage working capital.

These papers are usually bought by money market funds or by mutual funds that invests in short term papers.

The problem lies with the asset-backed commercial paper market or short term vehicle issued by financial institutions backed by physical assets such as receivables (mortgages, bonds, credit cards, car loans or other trade receivables), some of which had been collateralized by subprime mortgages.

Where many of the pooled investment vehicles as the Structured Investment Vehicles (SIVs) used by banks and sold to the public had been borrowed in the form of asset-backed commercial papers, the losses in the US subprime sector has resulted to a freeze in financing due to the questionable valuations of these vehicles.

In effect, the liquidity freeze in the commercial paper space has crimped on the access to financing by corporations to manage their day-to-day operations. This has likewise raised the cost of borrowing, and increased the risks of corporations raising cash by selling other assets in order to raise cash.

PIMCO’s managing director Mr. Paul McCulley labels such developments equivalent to a bank run but in the form of “The Shadow Banking System”, where in his outlook, Mr. McCulley wrote (highlight mine),

``Technically, that’s called systemic risk. And in the current circumstance, it’s called a run on what I’ve dubbed the "shadow banking system" – the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.

``Unlike regulated real banks, who fund themselves with insured deposits, backstopped by access to the Fed’s discount window, unregulated shadow banks fund themselves with un-insured commercial paper, which may or may not be backstopped by liquidity lines from real banks. Thus, the shadow banking system is particularly vulnerable to runs – commercial paper investors refusing to re-up when their paper matures, leaving the shadow banks with a liquidity crisis – a need to tap their back-up lines of credit with real banks and/or to liquidate assets at fire sale prices.”

In Friday’s commentary, the cautiously bullish BCA Research (see figure 1), seeing the continued pressures in the credit markets, now joins the ranks of those calling for rate cuts…

Figure 1: BCA Research: Monitoring the Credit Crunch

Quoting BCA Research, ``The price of credit remains elevated in many areas. The asset-backed commercial paper market remains locked up, with investors seemingly unwilling to buy at any price. Term financing is difficult to get and this, along with nascent banking sector concerns, has contributed to the ongoing elevation in LIBOR rates and the fed funds-LIBOR basis swap. The 2-year swap spread also continues to widen towards the previous peak. Similarly, both corporate bond and CDS spreads are grinding higher. Perhaps most worrisome, the price of debt for some consumers has also surged, as indicated by the recent blowout in the 30-year fixed jumbo mortgage rate. It is when creditworthy customers cannot access credit that the Fed must step in and deliver relief.”

So how are rate cuts supposed to help?

The lowering of rates aims to reduce the impact of higher borrowing spreads and potential loan losses. Remember, in a highly levered financial system, marginal moves reverberate! Yet, rate cuts cannot be taken with certitude that confidence will be restored, especially if the damage has been widespread.

All told, despite the gradual progress seen in the equity markets, the credit markets tell us that ALL IS NOT NORMAL and that the present liquidity drought has been seen affecting a broader part of the global economy. This suggests to us that the downside risks are far greater than what the consensus expects.